A202 Chapter 11

Capital Budgeting
the set of tools companies use to evaluate the value of large scale expenditures
Drawbacks of using allocation for decision making
1 doesn't account for time value of money
2 doesn't account for the lumpy nature of capacity resources
Time Value of Money
arises because a dollar today is worth more than a dollar tomorrow
Money is a....
productive asset. it's opportunity cost is the time value of money
How does capital budgeting account for time value?
by discounting future cash inflows and outflows to their present value
Cost allocation and the lumpiness of capacity resources
estimates costs as if we can match supply and demand continuously and smoothly
Capital budgets link...
strategic and operating budgets
Two steps of Capital Budgeting
1 identify and evaluate individual investment proposals
2 prioritize the proposals and decide which one to execute
Four important elements of a capital expenditure decision
1 initial outlay
2 estimated life and salvage value
3 timing and amounts of operating cash flows
4 cost of capital
initial outlay
all cost incurred to ready the asset for its intended use
Salvage value
the residual value from disposing of the asset at the end of its useful life
Cost of capital
the opportunity cost for money (rate of return investors expect to receive from investment)

aka discount rate
Discounted cash flow techniques
1 npv
2 internal rate of return
NPV
the total present value of all of its cash flows
IRR
the discount rate at which a project has zero NPV
IRR and unequal cash flows
use excel or other computer programs to find the IRR
IRR with equal cash flows
refer back to a201. it is the percentage that can be found on an annuity table
Three other methods used to evaluate expenditures on long lived resources
payback, modified payback,and accounting rate of return
Payback period
compute how long it takes to recoup the initial investment using undiscounted cash flows
Modified Payback Method
computes the payback period using discounted cash flows, meaning that the method accounts for the time value of money
Accounting rate of return
(average annual income from the project)/ (average annual investment)
Accounting income
annual net cash flows - annual depreciation expense
Average book value
(open book - depreciation)= end book.

average = (open + end)/2
Taxes are paid on....
accounting income
Tax shield
the term of using depreciation to lower taxable income
Depreciation tax shield
tax rate x depreciation deduction in that year
hurdle rate
the minimum expected rate of return of the management from any project
Flexibility
the ability to defer, abandon, expand, or contract an investment
increasing a firms future flexibility is a key...
element of value, particularly for projects with considerable uncertainty in their estimated cash flows
Real options analysis
complements standard techniques such as npv and irr with sophisticated mathematical models to place a quantitative value on flexibility